What’s beloved by financial planners, your parents, and millionaires? Yep, it’s a 401(k). Having money taken out of your paycheck automatically has never looked so good.
Remind me, what's a 401(k) again?
A 401(k) is a retirement savings plan that you open through your employer. How it works: A percentage of your income (typically 10-15% of your annual salary is recommended, but you decide) is taken out of your paycheck pre-taxes (at least in a traditional 401(k) account— more on that later).Whatever amount you contribute is invested in your future.But there’s one catch: You can’t touch it without fees and penalties until at least age 55. (Hint: You can contribute up to $20,500 per year to your 401(k) in 2022.)
Got it. And why do I need a 401(k)?
Spoiler alert: Social Security payments alone won’t cut it for your retirement. The average Social Security payment in 2022 is $1,657, aka probably not enough to live on. That’s where your 401(k) savings come in.
Okay, what else is in it for me?
You can potentially get free money from your employer. Yep, you read that right. If your employer offers a 401(k) match, your company could double your contributions, up to a certain percentage of your income. (Score.)
Another pro: A traditional 401(k) can help you lower your taxable income. And lower income = lower taxes. Psst… you will pay taxes eventually, but it’ll be later. When your withdrawals are taxed as income in retirement. Wanna save later instead of now? Meet the Roth 401(k), more on that in a minute.
A 401(k) is also an easy and automatic way to secure that bag for your future. And it needs to be secured. Because ICYMI, women need to save more than men for retirement. A 401(k) makes it simple and crosses “save for retirement” off of your to-do list. So you can focus on living your best life now and later.
So there are traditional and Roth 401(k)s. How do I know which is right for me?
Yep, there are two types of 401(k)s that are likely available to you. The main difference is when you get tax breaks: Now or later. A traditional 401(k) gives you tax breaks now. Because the money that goes into your account will be taxed later when you withdraw it in retirement. With a Roth 401(k), the money doesn’t get tax breaks now. Instead, you pay taxes upfront and have it tax-free in retirement.
Do I have to use my employer's 401(k)?
There’s absolutely no requirement to use your employer’s 401(k). It’s optional. But there are plenty of reasons why you’d want to. #1 being you don’t want to miss out on free money if your employer offers a match. If you can afford to take advantage of the max match limit, it could help you save big time.
Okay, and what’s the difference between a 403(b) vs 401(k)?
If your employer doesn’t offer a 401(k), but they do have a 403(b), don’t sweat it. They function similarly. A 403(b) is a retirement account for employees of public schools (hi, teachers) or other tax-exempt organizations like religious organizations or charities. They might have slightly different investment options, but a 403(b) and a 401(k) both help you get to the same goal. Aka a comfy retirement.
What about an IRA vs 401(k)?
An IRA doesn’t always have the same tax advantages that a 401(k) does. (Though a traditional IRA could help you to lower your taxable income.)
Another reason to have both: IRAs don’t offer you much room to contribute. In 2022, you can only contribute $6,000 per year to an IRA (or $7,000 if you’re over age 50). A 401(k) lets you save $20,500. Having both = saving more for retirement.
Plus, later on, you’ll have options. You can choose which account to pull money from. And that could be helpful depending on your situation.
One example: Say you retire at age 55. If you have a 401(k), you can use what’s called the “Rule of 55” to live on funds from it. That rule doesn’t apply to your IRAs — you won’t be able to pull from those until age 59 1/2.
Another scenario: You might want to have the option to take money tax-free from a Roth account in retirement. You would have to pay taxes on money withdrawn from a 401(k). Having more options for paying taxes on your money will help you rest easy in retirement.
Are there alternatives to a 401(k) for small businesses? Or self-employed people?
When you’re self-employed or working for a small business that doesn’t offer a 401(k) plan, a SEP IRA could help you save. The limits on this account are much higher than other types of IRAs, at either 25% of your pay, or $61,000, whichever is lower. While it’s not a 401(k), it should help you build up your retirement funds.
If I open a 401(k) through my employer, what happens when I quit?
The short answer: A rollover. Aka moving those funds from your old employer to your new employer. Lucky for you, we’ve Skimm’d the rollover process from start to finish.
Saving for retirement is important. And a 401(k) makes it easy to automatically contribute funds for Future You to spend.
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